It’s that time of the season again where we have to start thinking about our tax returns. With that comes the decision of whether or not to contribute to our RRSPs in order to give ourselves a tax “refund”. I’ve written before about RRSPs and explained 5 other ways an RRSP can benefit yourself, but many individuals still don’t understand what an RRSP is and why we should even contribute to them. If you’re still confused about what an RRSP is then head on over here to read about it.
On a year to year basis only about 1/4 of Canadians actually contribute to their RRSPs. Perhaps Canadians don’t understand the importance of saving, but the paltry participation rate suggests that many Canadians don’t really care about RRSPs. For the individuals that actually use the RRSP there is always a lot of confusion about whether the benefits of contributing outweigh the cons. Depending on the circumstances of a person’s current financial situation, contributing to an RRSP may not always be the most prudent choice.
Since no one has ever taught us anything about personal finance how do we know what to do?
Let’s get things straight. I put the word “refund” in quotes in the first paragraph for a reason. That’s because contributing to your RRSP is for deferring taxes to a later date, not avoiding taxes completely. The original purpose of the RRSP was to save for retirement and allow individuals to grow their money tax free and then withdraw it at a later date. When money is taken out at the later date, the money would be taxed. This all amounted to deferring when taxes were paid to a future date.
With this in mind, it’s important to strategize how to best take advantage of the RRSP. This means the RRSP is more advantageous to individuals who feel that they will be in a lower tax bracket when they retire. I’ve written about how taxes work in Canada, so the most important question individuals should ask themselves is “do I expect to make more money when I retire than I do right now?” If the answer is yes, then perhaps the RRSP is not the best way to invest your money. For the majority of individuals the RRSP still makes a lot of sense, especially those who expect to retire and only have their home as their only asset.
If the sole purpose of using RRSP is to avoid paying taxes, then you are doing it wrong. There are no ways to avoid taxes. If anyone ever tells you that you that you should be contributing to your RRSP to avoid paying taxes, step back, turn around and run quickly. Don’t look back. Ignore their screams. That person was just about to give you some terrible financial advice.
If you are one of the few lucky ones left that have a defined pension at your workplace and it restores almost 75% or more of your income in retirement, then the RRSP is definitely something you probably want to avoid. Most defined pensions will pay out at a rate near your last 5 years of employment. For most individuals, this will be close to the highest paying years in your working life.
What this means is that regardless of when you contribute to the RRSP, you’ll most likely be making more money in retirement than your early working years. Since the RRSP is used to defer taxes and you pay more taxes in a higher income bracket than a lower one, the money in the RRSP will get taxed at a much higher rate when it is taken out.
In the case that you have a defined pension plan, there are better savings vehicles like the TFSA that you should be contributing to before the RRSP.
Investing For The Future
Regardless of what you plan on doing with your RRSP, the money in there should be invested for future growth. The greatest asset of having an RRSP account is that the money can grow tax free while in the account. This is extremely advantageous because it helps us achieve our financial goals faster. It almost maximizes our ability to use compound interest in order to build our portfolio quicker because the government isn’t taxing our gains.
An RRSP is a perfect place to build a diversified investment portfolio that has a long term objective. I’ve mentioned before that one of my favourite investment strategies is to follow the model portfolios on the Canadian Couch Potato site. The 2015 portfolios are even better now that they provide a different portfolio for different risk profiles.
What individuals don’t want to do is use their RRSP as a glorified savings account. GICs and interest from the banks return such minuscule amounts that even inflation is outstripping the gains. If you’re still not confident in building your own investment portfolio then it’s prudent to get some financial advice from a financial advisor.
It’s Not Just For The Rich
Saving a little goes a long way. Even if you’re just scraping by it’s important to save a little. Sometimes the tiniest change in our behaviour frees enough precious dollars that we can used to build wealth for our future. In the world that we live in, money makes money, buying things don’t. Since the government has given us a way to build wealth in the form of an RRSP account. why not take advantage of it? I have, why wouldn’t you?